Last update: Dec 2020
As a liquidity provider in individual option markets, your role is to facilitate the ability for users to buy options. In exchange, you are paid a trading fee: Uniswap's pair fee of 0.30%. Primitive V1 leverages Uniswap pairs as a trading venue for option tokens.
Liquidity providers will be providing short option tokens and underlying tokens of that option to Uniswap pairs. Short option tokens are a new primitive that the protocol has developed, which are redeemable for underlying tokens in the case the long options expired, or redeemable for strike tokens if long options were exercised.
Short option tokens are extremely interesting because they have a bounded value! They are at least worth the strike tokens if the long options were exercised. This is a critical feature to have for a token, bounded value, because Uniswap pairs cannot handle tokens that decay towards zero. Long option tokens decay towards zero on their expiry date, which becomes a problem for liquidity providers of long option tokens. If a token is worth zero, but exists in a Uniswap pair, those worthless tokens can be swapped to the other token in the pair, effectively selling the token with value for a token worth zero. Liquidity providers would end up to owning a pool full of worthless tokens... The solution to this is to only have tokens in the pool which have a bounded value.
The short options are directly tied to the underlying tokens. Here's an explanation of how Primitive V1 option tokens work:
Primitive V1 option tokens are physically settled, American options, which means the underlying assets are held in the smart contract and can be exercised whenever. Holding the long (actual option) tokens gives the user the right to purchase the underlying tokens at a strike price defined in the smart contract, a value that is immutable. To mint long and short options, underlying tokens are simply deposited. The option has the parameters base and quote, base is the quantity of long options which are minted per one underlying token, and quote is the quantity of short options which are minted per underlying token. Short option tokens are simply a receipt for the underlying token deposit, rights to claim whatever is remaining of that deposit (underlying if expired, strike if exercised).
To summarize, depositing underlying tokens gets you long and short options!
As liquidity providers, only the underlying token is required! Some underlying tokens get provided as liquidity, and the remainder of underlying tokens get used to mint short options which are provided as liquidity.
As trading occurs over time, the ratio of underlying and short tokens will change. When compared to the original deposit, you may have more long or short tokens in your balance than you started with, after the long and short options are netted out. This option exposure leaves you as an LP exposed directionally to the option, which can be fixed by selling the short/long tokens or hedging using other instruments.